I will be participating in what promises to be an interesting panel discussion on the Mayo Foundation decision on Monday February 28 at 1:00 EST. The other two distinguished members of the panel are: Gil Rothenberg, Chief of the Appellate Section of the United States Department of Justice’s Tax Division, who is also currently serving as Acting Deputy Assistant Attorney General for Review and Appellate; and Emily Parker, partner at Thompson & Knight LLP, and former Acting Chief Counsel and Deputy Chief Counsel for the IRS.

We noted back in November that the taxpayer had filed a petition for certiorari in Kawashima v. Holder, 615 F.3d 1043 (9th Cir. 2010), on the question whether Code section 7206 offenses provide a basis for deportation — an issue on which the circuits are split. We stated that the Court could be expected to rule on the petition in early 2011, even if the government obtained a fairly routine 30-day extension of its December 2, 2010 response date.

There is no ruling yet because the government has now obtained three such extensions. That is fairly unusual and may indicate that the government’s lawyers are struggling with how to respond. In any case, it is unlikely that the Court would grant another extension. If a response is filed on the current due date of March 4, 2011, then the Court will likely issue its ruling on its April 4 order list.

The Fifth Circuit announced today its ruling in favor of the taxpayer in the two consolidated cases pending before it on the Intermountain issue, Burks v. United States, and Commissioner v. MITA. As we previously noted, the Fifth Circuit had decided what the government regarded as the most favorable precedent on this issue before the Son-of-BOSS cases, Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968), but the court at oral argument appeared to be leaning towards finding that case distinguishable. And so it did, creating the anomaly that the Seventh Circuit in Beard has given Phinney a much broader reading than the Fifth (see here). In any event, the Fifth Circuit rejected the reasoning of Beard and concluded that Colony is controlling with respect to the meaning of the phrase “omits from gross income” in the 1954 Code. The court addressed this argument in some detail, relying heavily on the “comprehensive analysis” of the Ninth Circuit in favor of the taxpayer’s position in Bakersfield Energy Partners, LP v. Commissioner, 568 F.3d 767 (9th Cir. 2009).

The court devoted comparatively little attention to the government’s reliance on the new regulations. It concluded that the statute was unambiguous and therefore there was no basis for affording deference to the regulations. In addition, the court stated that the new regulations by their terms were inapplicable because they should be read as reaching back no more than three years — an argument accepted by the Tax Court majority but that does not appear to be among the taxpayers’ strongest, especially after the final regulations were issued.

The most provocative discussion in the opinion is a long footnote 9 near the end, which points out some possible limitations on the impact of the Supreme Court’s recent Mayo Foundation decision (discussed here). Although its conclusion that the statute is unambiguous made the regulations irrelevant, the court went on to state that it would not have deferred to the regulations under Chevron even if the statute were ambiguous. On this point, the court emphasized an important difference between Mayo and the Intermountain cases — namely, the retroactive nature of the regulations at issue in the latter cases. Noting that the Supreme Court has said that it is inappropriate to defer “to what appears to be nothing more than the agency’s convenient litigating position” (quotingBowen v. Georgetown Univ. Hosp., 488 U.S. 204, 213 (1988)), the Fifth Circuit stated that the “Commissioner ‘may not take advantage of his power to promulgate retroactive regulations during the course of a litigation for the purpose of providing himself with a defense based on the presumption of validity accorded to such regulations'” (quotingChock Full O’Nuts Corp. v. United States, 453 F.2d 300, 303 (2d Cir. 1971)). In addition, the court questioned the efficacy of the government’s request for deference to final regulations that were largely indistinguishable from the temporary regulations: “That the government allowed for notice and comment after the final [perhaps should read “temporary”] Regulations were enacted is not an acceptable substitute for pre-promulgation notice and comment. See U.S. Steel Corp. v. U.S. EPA, 595 F.2d 207, 214-15 (5th Cir. 1979).”

Thus, we have perfect symmetry between the conflicting decisions of the Fifth and Seventh Circuits. The Seventh Circuit says that the statutory language supports the government, so there is no need to consider the regulations. But if it did consider the regulations, it would defer. The Fifth Circuit says that statutory language unambiguously supports the taxpayer, so there is no justification for considering the regulations. But if it did consider the regulations, it would not defer. The Supreme Court awaits, and it may well have something to say about the Fifth Circuit’s observations in footnote 9.

We present here a guest post from our colleague Kevin Kenworthy, who has considerable experience representing taxpayers on the issue of creditable foreign taxes.

The Tax Court’s two companion decisions in PPL Corp. v. Commissioner, 135 T.C. No. 8 (Sept. 9, 2010) and Entergy v. Commissioner, T.C. Memo 2010-166 (Sept. 9, 2010), raise an important question concerning whether a 1997 Windfall Tax imposed by the U.K. government on previously privatized industries is a creditable income tax under U.S. rules. The cases were tried separately before Judge Halpern and addressed in companion opinions issued simultaneously that ruled for the taxpayer (with the analysis contained in the PPL opinion). The opinions are linked below. The government has now appealed these cases to the Third and Fifth Circuits respectively. (The Tax Court cases, in opinions issued a few weeks earlier, also addressed an issue concerning the appropriate recovery period for depreciation of an electric utility’s lighting assets, but it appears at this point that the government does not plan to contest that issue on appeal.)

Under section 901 of the Code and related provisions, a U.S. taxpayer can elect to credit, rather than deduct, qualifying income taxes paid to a foreign country. Only income taxes are eligible for this credit; non-income taxes can only be deducted in computing taxable income. In determining whether a foreign tax is creditable, the ultimate inquiry is whether the levy is an income tax in the U.S. sense of the term. The governing regulations provide a specific framework for assessing whether a foreign tax meets this test, including requirements that the foreign tax meet a three-part test aimed at determining whether the tax will reach net gain in the ordinary circumstances in which it applies. Treas. Reg. § 1.901-2.

The U.K. Windfall Tax is an unconventional levy in some respects, resulting in part from its unique origins in British politics. In the early 1990s, Conservative governments continued a policy of privatizing what had previously been government-owned monopolies, including regional electricity companies, through a series of public stock offerings. The privatizations were anathema to traditional Labour Party tenets. Moreover, the newly privatized entities, although they continued to be subject to price regulation, proved to be quite profitable in the years following privatization. In 1997, the new Labour government announced a tax aimed at “windfall profits” previously realized by the formerly government-owned enterprises. The tax was justified by assertions that windfall profits resulted from the prior government’s decision to sell off the companies at too low a price, compounded by its failure to subject the privatized companies to adequate regulation.

The Windfall Tax was designed as a one-time, retrospective tax imposed on the privatized utilities. The new tax was imposed on the basis of a unique formula that started with the average book profits of these enterprises over the first four years following privatization multiplied by nine, an amount characterized by the statute as the “value in profit-making terms.” Tax at a rate of 23% was then imposed on the excess of this artificial earnings multiple over the initial market capitalization (the “flotation value”) of the shares. The tax was imposed on the companies directly, rather than on the initial private shareholders, many of whom had long ago sold their shares.

The taxpayers argued that the creditability of the Windfall Tax could be established by examining the actual operation and effect of the tax. The taxpayers showed that the statutory formula could be restated algebraically to reveal that the Windfall Tax operated in almost all cases equivalently to a tax imposed at a rate of roughly 50% on profits realized over a four-year period. Based in large part on this equivalence, the taxpayers argued that the Windfall Tax was essentially an income tax and satisfied the regulatory test for creditability. The IRS countered that the creditability of the Windfall Tax could be evaluated only by reference to the statutory language and that resort to extrinsic evidence of the type offered by the taxpayers was inappropriate. Further, the IRS argued that the statute’s apparent reference to valuation principles, rather than to conventional measures of net income, leads to the conclusion that the Windfall Tax is not creditable. Drawing ample support from the regulations themselves and from prior court decisions, the Tax Court refused to limit the creditability inquiry in this manner and found the Windfall Tax to be creditable.

The government’s opening brief in Entergy is due March 14, 2011. No briefing schedule has yet been established in PPL.

The Fourth Circuit, in an opinion authored by Judge Wynn and joined by Judges Wilkinson and Gregory, has solidified the circuit conflict on the Intermountain issue by ruling for the taxpayer in the Home Concrete case. (See our original post on these cases here.) First, the court held that the statutory issue was resolved by the Supreme Court’s decision in Colony, rejecting the argument recently accepted by the Seventh Circuit in Beard (see here) that Colony addressed the 1939 Code and should be understood as applying to identical language in the 1954 Code only to the extent that the taxpayer is in a trade or business. The court concluded that “we join the Ninth and Federal Circuits and conclude that Colony forecloses the argument that Home Concrete’s overstated basis in its reporting of the short sale proceeds resulted in an omission from its reported gross income.”

Second, the court held that the outcome was not changed by the new Treasury regulations. The court held that the regulations by their terms could not apply to the 1999 tax year at issue, because “the period for assessing tax” for that year expired in September 2006. See Treas. Reg. § 301.6501(e)-1(e). The government argued that the new regulations apply to all taxable years that are the subject of pending cases, but the court held that this position could not be squared with the statutory text of Code section 6501. In any event, the court continued, no deference would be owed to the regulations under the principles of Brand X because the Supreme Court had already conclusively construed the term “omission from gross income” in Colony and therefore there was no longer any room for the agency to resolve an ambiguity by regulation.

Judge Wilkinson wrote a separate concurring opinion to elaborate on this last point. He observed that Brand X allows a regulation to override a prior court decision only if that decision was not based on a Chevron “step one” analysis — that is, on a conclusion that the statute is unambiguous. This can be a difficult inquiry when examining pre-Chevron decisions in which the court had no reason to analyze the case through the lens of the two-step Chevron framework. Judge Wilkinson explains why he “believe[s] that Colony was decided under Chevron step one,” concluding that the Supreme Court’s statement that it could not conclude that the 1939 Code language is unambiguous was “secondary in importance to the thrust of the opinion” and the Court’s assessment of the statutory purpose. (As previously discussed here, this question of whether Colony should be viewed as a “step one” decision, and the related question of how relevant legislative history is at “step one,” was the focus of the Federal Circuit’s attention in the oral argument in Grapevine.)

Judge Wilkinson then goes on to make some more general observations about the limits of Chevron deference in the wake of the Mayo Foundation case. He states that Mayo “makes perfect sense” in affording “agencies considerable discretion in their areas of expertise.” He cautions, however, that “it remains the case that agencies are not a law unto themselves. No less than any other organ of government, they operate in a system in which the last words in law belong to Congress and the Supreme Court.” In Judge Wilkinson’s view, the government’s attempt to reverse Colony by regulation “pass[es] the point where the beneficial application of agency expertise gives way to a lack of accountability and a risk of arbitrariness.” He concludes that “Chevron, Brand X, and more recently, Mayo Foundation rightly leave agencies with a large and beneficial role, but they do not leave courts with no role where the very language of the law is palpably at stake.”

The Fourth Circuit’s decision seems to eliminate the slim possibility that the Intermountain issue could be definitively resolved short of the Supreme Court. There are now two circuits (the Fourth and the Seventh) that have come down on opposite sides, though both had the opportunity to consider the recent developments of the final regulations and the Mayo decision. At this point, the government is likely to seek Supreme Court review, either by acquiescing in a taxpayer certiorari petition (possibly in Beard) or by filing its own petition in Home Concrete. Unless petitions for rehearing are filed, the parties have 90 days from the date of final judgment to file a petition for certiorari in these cases.

The government has filed its reply brief in the D.C. Circuit in Intermountain. Although there are no surprises, the brief is a useful resource because it contains in one place the government’s arguments concerning three recent developments favorable to its case, which it has been calling to the attention of other courts piecemeal in supplemental filings. Those developments are the Seventh Circuit’s Beard decision (see here); the Supreme Court’s decision in Mayo Foundation (see here), and the issuance of final regulations (see here). Despite its recent victory in Beard on purely statutory grounds, the government still seems to believe that Chevron deference to the new regulations is its best bet. The reply brief devotes 3 pages to the statutory argument and 23 pages to the regulatory deference argument.

We have added DOJ’s brief to the original post. Nothing much surprising in it; the arguments adopted reflect the same approach taken in our initial post (and in the Court of Federal Claims). A point of interest is that there are 30 related cases holding at the Court of Federal Claims that depend on its resolution. We will update you as soon as we hear what the en banc court does.

About Miller & Chevalier’s Tax Appellate Blog

Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.